Friday, November 28, 2014

Threading the Fiscal Needle

PALO ALTO – Elections often turn on the state of the economy, especially in hard times. When growth and jobs are down, voters throw out incumbents – whether Spanish leftists, French rightists, or Dutch centrists. The United States is no exception. Three years into the Great Depression, Herbert Hoover was trounced by Franklin Delano Roosevelt. In 1980, following a severe bout of stagflation, Ronald Reagan routed Jimmy Carter.

At the same time, economic performance depends to a considerable extent on economic policy. The Great Depression was intensified by poor monetary policy, tax hikes, and protectionist trade policies. Likewise, loose US monetary policy in the middle of the last decade helped to set the stage for the Great Recession by contributing significantly to an explosion of leverage and fueling the housing bubble that burst in 2007-2008.

The outcome of two related policy battles will be key to the economic and political outlook in both the US and Europe. The first is between “austerity” and “growth” – that is, short-term deficit reduction and additional fiscal stimulus. Many on the left, on both sides of the Atlantic, argue that more, not less, government spending is required to lift their economies out of recession. Those on the right believe that governments’ top priority should be fiscal consolidation.

In Europe, large deficits and exploding debt-to-GDP ratios have alarmed creditors and provoked political tension. In particular, Germany demands more fiscal belt-tightening from heavily indebted Southern European countries, whose unions (and voters) are rejecting further austerity. While the US has thus far avoided the bond market’s wrath, American political leaders confront the same problem of debt and fiscal sustainability.  

The second battle involves long-run structural issues: slowing the growth of government spending, reforming taxes, and increasing labor-market flexibility. In Europe, for example, raising the retirement age for public pensions and shrinking government employment would curtail welfare-state excesses.

In the US, Reagan’s victory in 1980 appeared to signal that America would stop well short of the European social-welfare model. But President Barack Obama and his congressional allies have rejected the consensus that government should be only a last resort for those in need, in favor of greater dependence, for both individuals and firms, on entitlement programs and other public spending, targeted tax breaks, regulations, and loans.

Separating the budget’s effects on the economy from those of the economy on the budget is tricky. There are several cases – Ireland and Denmark in the 1980’s, for example – in which fiscal consolidation helped to expand the economy in the short run, as lower interest and exchange rates boosted confidence enough to stimulate demand.

Of course, if many of the world’s economies attempt to consolidate simultaneously, with interest rates already low and some of the largest in a monetary union, such a favorable result is less likely. But the evidence on whether additional deficit-financed spending would quickly revive economic growth is mixed.

In a recent survey, “Fiscal Policy for Economic Growth,” I concluded that short-run multipliers – the total change in economic activity resulting from higher government spending – could theoretically be as large as two when the central bank has reduced its target interest rate to zero. In other words, one dollar spent by the government could boost GDP by two dollars in the very short run.

The catch is that the multiplier turns negative by year two: extra government spending contracts, rather than expands, medium-term and long-term economic growth. Moreover, the short-run effect is lower in highly indebted countries, and can even be negative during economic expansions if households and firms, expecting higher taxes to pay for future spending, save, rather than spend, the cash.

Postponing fiscal consolidation risks aborting it, but consolidating too aggressively risks temporarily hindering growth. But those now demanding further deficit-financed stimulus must confront considerable evidence that an overhang of public debt impedes growth for a long time. In a recent paper following up on their book This Time is Different, the economists Carmen Reinhart and Kenneth Rogoff concluded that debt/GDP ratios above 90% tend to be associated with an annual growth slowdown of a full percentage point for 23 years. Thus, a debt overhang cumulatively costs more in lost income than a deep recession does.

Wise policy simultaneously considers short-, medium-, and long-term effects. Both Europe and the US badly need long-run reforms, for example, of public pensions and health care. Europe requires structural labor-market reform and must resolve its sovereign-debt overhang, banking crises, and the euro’s future. America must reform its tax code to raise revenue across a wider array of people and economic activity (half the US population pays no federal income tax, and the tax code either excludes or favorably treats many income sources).

Over the next several years – the medium term – all countries should implement difficult-to-reverse fiscal consolidation, which would persuade the private sector that a gradual or delayed adjustment, primarily on the spending side of the budget, will occur. Successful consolidation generally relies on spending cuts rather than tax increases – indeed, at a ratio of five or six to one. The US in the 1980’s and 1990’s reduced spending by 5% of GDP and balanced its budget while growing strongly. Canada, in the past two decades, has decreased spending by 8% of GDP and similarly prospered.

In the short run, spending flexibility is appropriate only if medium- and long-term measures are in place. That compromise – between Germany and Southern Europe, and between US Republicans and Democrats – should be economically and politically feasible.

With many citizens now struggling, political leaders face a daunting task: adopt credible medium- and long-term reforms without derailing the economy in the short term. They have little economic – and perhaps even less political – margin for error.

Read more from our "Austerity and its Discontents" Focal Point.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (9)

    Please login or register to post a comment

    1. CommentedVan Poppel charles

      Threading the Fiscal Needle: professor I read your article in belgian financial paper; it is very sophistocated but it makes me think at what Keynes wrote about the Hayek book " The road to serfdom" that anti-planning pamphlet " your book is a grand book, and we have the greatest reason to be grateful to you for saying so well what needs so much to be said .. but you give us no guidance.

    2. CommentedZsolt Hermann

      Answer to Thomas Adam:
      Sorry Thomas and everybody else for the excessive writing, but as Thomas suggested I say something EXACT I suggest a scenario:
      As the crisis is deepening the leading politicians and the top social layer who benefited most from the present system starts to understand that either they also lose everything or the angry public will want to take it from them or both.
      As a result they become willing to listen to the suggestions that we need to change the system and also explain the people why it needs to change so there will be no revolutions, wars, and so on.
      So instead of continuing to pump the brain of the public with marketing so they keep on buying the unnecessary, harmful products so the 1% have more profit, they assemble those professionals, scientist who have already been exploring and publishing what system we exist in and how we should adjust to it, also people who can put it together into a coherent full picture, and then start to broadcast it to everybody as a free, virtual, open education program. They might even package it to unemployed people (whose number will continue to rise exponentially into billions) together with the dole, that instead of wasting their time they study certain time every day.
      We know that in the Internet age spreading a general idea or desire world wide takes hours or days.
      And then based on this general understanding the experts in economics, politics, sociology, health sciences, and so on can start building the new system.
      And although the new system is very different, almost opposite to the old one, since everybody got a basic understanding of the situation people would accept it willingly.

    3. CommentedZsolt Hermann

      Answer to Thomas Adam:
      I do not know what exactly you expect, what secrets you would like me to disclose.
      We evolved through multiple factors into a global, integral world where each and every human being depends on the other. Besides we live in a closed, finite system where the "constant quantitative growth, expansive economic model" cannot work infinitely. These two factors combine to give us the global crisis.
      I did not invent this, please search the internet for those keywords I typed into this comment, or search Project Syndicate for related articles.
      Do you see any solution on the horizon from any leading expert or politician at the moment? Have they come up with any future plan at the G8 or G20 meetings?
      They still try solutions from within the same framework where we run into the crisis.
      Has anything changed from the conditions that caused the 2008 banking crisis, apart from pumping trillions of dollars into the system trying to cover up the shortcomings?
      Is there any sign anybody tries to solve social inequalities?
      Do you see any true breakthrough in creating more jobs?
      Is there not enough evidence how much all of this effects each and every country, and for example the daily events of the Greek situation has a profound effect on Wall Street or other global markets?
      Of course it is a very bitter pill to accept that our present lifestyle self destructs and we ourselves have to change instead of continuing to point fingers at imagined scapegoats, trying to change governments, demonstrate on the streets, or wait for heroes or prophets to come with miracle solutions so we can continue life as if nothing happened.
      But we already have all the scientific data supporting what I commented, none of it is my own idea, I am just repeating what I heard and read.
      If we are wise we try to understand what this new state means and adapt to it, this is why we need education, spreading the already available data the Internet is full of in a comprehensive accessible format for everybody, because the whole of humanity has to change.
      Which question did I not answer?
      In terms of nature every living system thrives to achieve balance, homeostasis, and each element except humans do it automatically. At the moment we are like cancer cells because we apply an excessive, vastly beyond necessities approach to life.

    4. CommentedZsolt Hermann

      Answer to Shan Jun Chang (continued):
      We are making two major mistakes when we evaluate ourselves:
      1. We think we are above nature and we can do whatever we want.
      2. Evolution somehow stopped, and we do not need to adjust any more.
      I do not see why mentioning natural laws, or nature would be esoteric. Our whole life is based on natural laws we use each and every second, our biological body works by the same laws any other living creatures work. All human inventions, discoveries are simply revelations of nature, copying patterns, functions we discover from nature. There is nothing esoteric in this it is pure science.
      I try to give you a more technical example about what is happening today. Imagine you work on your computer one day and you do all the tasks you have to do. Next day you try to do the same but somehow nothing works, whatever you try everything freezes, and all the experts you are calling trying the usual recovery methods fail as well. Then you realize that while you were "away" somehow the operating system changed, none of your previous programs, solutions work, you have to install completely new programs, you have to learn the new operating system.
      The change of operating system is called evolution. And today we are in a completely new operating system.
      The global, integral, interdependent human network is this operating system and we can only progress if we get to know all its details and the laws it is working by.

        CommentedThomas Adam

        As I see it, Mr Hermann, you still haven't answer his question, because you've basically said over and over again in different ways, "we must understand the natural laws because our world is evolving". I want to know is what EXACTLY these laws are, how EXACTLY the world is evolving, and how your single substantive proposal " novel global education" is supposed to work. If you can't do this, then you're wasting comment space.

    5. CommentedZsolt Hermann

      Answer to Shan Jun Chang:
      What I was commenting is not mystical or esoteric. Even on this very website you will find many articles where respected experts are saying the same things, maybe my use of words is not the best, but you can find the same meaning in strictly scientific fashion in other places.
      And if you read my other comments you could see that the first step in any direction is knowledge, going in a direction we know instead of reacting like headless chicken, just rehashing and trying again all the solutions we tried before and failed with.
      There is no overnight solution snapping our fingers as we get used to from this Hollywood culture that the hero comes and turns everything upside down immediately.
      We have to study reality around us as seemingly nobody understand what it means to live in a global, integral world where we depend on each other, and what it means that in a closed finite world with our present lifestyle we exhaust our resources within our lifetime. We can only act when we have an understanding where we are and where we should be heading.
      Thus the solution you are asking for is a global education program for everybody, we are in a completely new situation without any historical example or precedent, with our old methods we keep going against the wall.

    6. CommentedZsolt Hermann

      It becomes clearer each day that we are facing a situation all over the globe we have never been in before.
      The present financial economical system is stuttering, even the political structure is failing stumbling from one deadlock to another both on national levels, and also internationally.
      Additionally we realize we live in a global, integral world with such interconnections that make us interdependent in a way we never experienced all through our history.
      We still behave like we always did, thinking we are above the vast natural system we exist in and we keep stubbornly devising newer and newer plans, and solutions, usually repeating the same ones which failed before.
      The first wise step we could take is the recognition that we are actually not in control. Now when even the human institutions we ourselves built are slipping through our fingers, from democratic institutions to economics and finances, from education to health services, from art and culture to environmental issues, it is time to take stock and stop for a minute.
      We are like a swimmer who desperately tries to swim against a very fast current that wants to take him somewhere but he stubbornly decides we want to go in another direction although he does not stand a chance.
      We are living in a vast, natural living system with unbending natural laws, driving the whole system towards homeostasis, an overall harmony. All elements of nature in the Universe, except humans, follow the natural laws blindly, automatically on an instinctive level.
      Humans are the only living creatures with a free choice, but so far and even at the moment we use our free choice for our own selfish benefit, exploiting everything and everybody around us, but by today with this attitude we have positioned ourselves in total opposition with the rest of the system. Thus we are sinking deeper and deeper in crisis.
      We have no choice against this system, our only choice is in learning the laws in all their details, and adapting to them, but since we would do it consciously, with our free agreement we would become "owners" of the system knowing exactly how to maintain its balance, elevating our existence onto a whole new level, revealing such opportunities and resources we haven't even dreamed about before.
      Of course we could also choose to continue playing our present games, adjusting finances here and there, electing presidents without any free choice and live life obliviously until we can, it is all up to us...

        CommentedShan Jun Chang

        Oh masterful Sensei! Please spare us the metaphor and esoteric bollocks and tell us what exactly these natural laws of which you speak are? What are your policy recommendations? If you must insist upon tarring every single article on this website with your nascent state-of-nature theory, at least give the world some specific information about how we can "elevate our existence to a whole new level" instead of simply alluding to the possibility.

    7. CommentedPaul A. Myers

      As a downpayment on fiscal consolidation, next January 1 let dividends return to ordinary income status (where they were for about a century) and let the top income tier return to 39 percent from 35 percent. Return lower brackets to the old rates over the next half dozen years, starting with the highest first. Let's leave cant about revenue off the table.

      On the spending side, move forward on implementing Medicare cost containment measures. With regard to overall health care, implement health insurance exchanges sooner and be more tough minded about what is covered. Give consideration to including Ryan's Medicare proposals in the health insurance exchange mix. Spending at the end of the day is mostly about health care.

      Start thinking about a smaller Defense establishment.

      I think the American people are very similar to the 80 percent of Greeks who want to stay with the euro: they want the public goodies but aren't much interested in paying for them.